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Many market commentators have been predicting that commercial real estate is the next shoe to drop in the credit crisis. I've seen a handful of presentations with whopping statistics on the amount of outstanding debt that will need to be revolved in the upcoming years. However, there has not been the massive apocalypse in commercial RE. At least not yet.

And there actually may not be. At least for a long while. The reason is that early this year the IRS changed some rules to allow REITs to pay some or all of their dividends in the form of stock. Typically a REIT pays its dividend in 100% cash out of its funds from operations. Because it pays a certain percentage of all of its income as dividends, it gets favorable tax treatment as a REIT. Late last year when the credit crisis was in full swing, REITs suddenly had to reduce their dividends because their funds from operations were reduced. Additionally, the terms for renewing debt was highly unfavorable so many REITs were in a bind as to whether they could revolve the debt at all or even pay out a dividend. As you can imagine, failure to pay a dividend would cause investors to flee the REIT as the primary reason to even invest in one is for income.

So the overall prediction was that as REITs would need to renew their debt in massive proportions, the credit markets would continue to be frozen and many would become insolvent. However, that has not happened. Fortunately, this single IRS change has allowed REITs to continue to pay large dividends to shareholders by issuing the dividend partially or fully in stock. Thus, there has been no massive exodus and crashing of these REITs. With their stock intact or even elevated due to the recent market bounce, many REITs have even been able to issue stock to repay debt.

One potential side effect of this IRS change is that the current shareholder is diluted at each dividend payment. Essentially, by issuing more shares each quarter, the REIT is slowly diluting and watering down its own investors.

This form of dividend payment reminds me of PIK toggle notes. These "Payment In Kind" notes allow a debtor to defer payment of the debt and allow it to accrue for a certain period. In the LBO world, PIK notes are very favorable for the debtor because it allows the debtor to essentially change the terms of his loan if his cash flow is thin. As you can imagine though, the use of PIK notes are a clear indication of potential financial distress and in general are only issued during frothy boom times. Thus, it is surprising that in this time of financial crisis the IRS would allow payment of dividends in stock.

This either means that commercial RE will never have its projected crash. Or it means that the death will be slow and it will be inevitable.

One reader has commented that I seem to be going on a lot of tirades about the economy and the bailout and that this blog has seemingly taken a political bent. That comment is well taken and so I will post this final post about the bailout and the excessive governmental tampering with the free markets now. I promise to leave the topic alone after today and move on.

So now that it appears that the economy has bottomed, banks are paying back their TARP loans. This is good news but it seems that now banks are negotiating with the government to buy back the warrants owned by the government. These negotiations are apparently taking longer than necessary due to the government wanting a better price for the warrants.

I find this both awesome and disturbing. First let's start with disturbing. This is disturbing because the Fed essentially forced these banks to take the TARP funds even when the banks did not want them. Now, when the banks are trying to get out of TARP, the government is essentially forcing them to pay inflated prices to buy back the warrants. This is the ultimate form of federal manipulation in a transaction involving a public company. It is unacceptable and simply not fair to the shareholders of those companies.

Now on the other hand this is quite an awesome phenomenon from an investor's standpoint. Essentially, this investor (the government) has been able to force a transaction on a company that the company must do in order to survive. Then when that company has clearly demonstrated that it is going to survive and not become insolvent, the investor is trying to milk all it can from the company. It reminds me of the old days of hostile takeovers when raider firms would take over companies and strip them of all of their value.

What I don't understand is why the government would try and milk those same companies that they tried to prop up. Don't they want the banks to succeed financially and don't they want to restore shareholder value?

This may be the ultimate grind down or it may simply be another securities violation implemented by the government who essentially owns the marketplace. Either way, the backasswardness of it all hasn't seem to have caught the attention of anyone in the financial media. Hopefully, the buybacks of these warrants and closure of TARP marks the end of our government's manipulative intervention in the marketplace.

Every industry has its own "Grind Down". Perhaps it goes by another name, but our firm refers to a "Grind Down" as a negotiating tactic that occurs in deals when one party or the other at the last minute tries to achieve more favorable terms for itself or threaten to back out of the deal at a time so late in the game that the other party cannot find another transactor.

Most homeowners have experienced the common retail mortgage grind down where when you go to buy a house and the deal is about to happen that the lender has some funny stuff fees in the transaction that you must pay. It is too late to find another lender and failure to go through with the deal opens up the property to another buyer. The other common grind down is from one party who asks for excessive concessions after the inspection and then threatens to back out of the deal if those concessions are not met.

In any deal, particularly private equity negotiations, there are lots of Grind Downs. One way some firms put the press on their portfolio companies is by not letting other co-investors in the deal. In the initial investment the firm promises to feed the startup until a liquidity event. These assurances allow that investor to be the sole investor and prevents the need for the company to deal with multiple investors. However, inevitably the company burns through that round of cash and needs another round of funding. The investor presents a term sheet and drags on signing it until the company is nearly out of cash. Suddenly, they must change the terms of the term sheet and so the company must sign the deal with those terms otherwise become insolvent.

As in any transaction it is imperative to create a market for your investment so that you can get a competitive price.

Most of you know my views on what has been happening to our financial system. Ken Lewis' testimony today on being pressured by Bernanke and Paulson further confirms that the government is running the best damn prop show you will ever see in your lifetime. Not only are we printing money like there is no tomorrow in order to prop up our sad banks who destroyed themselves on bad bets, we are propping up the notion that our financial markets are sound and fair.

For those of you that don't know the deal with Bank of America and Merrill Lynch, essentially, the government told Ken Lewis that Bank of America had to buy Merrill at an inflated price otherwise he would suffer the consequences. The complete truth of the story has not come out yet, but Ken Lewis is a very bright guy and it is obvious that he was told to do the deal and to conceal that fact from shareholders. As you can image, government tampering with a financial transaction in this manner is a very big problem. It's also a big problem from a public shareholder perspective. It's obvious that shareholders could sue Bank of America because essentially the ML transaction was made on their dime. However, can they also sue the government? Can they sue the SEC? Or can the SEC sue the government? What happens when the managers of the very system that stands for fairness become corrupt? What happens when the bosses who the SEC report to end up being the ones who manipulated the market?

In this case, probably nothing. But mark my words, we have descended down a slippery slope and perhaps there is no return.

I can't help but wonder that if the guys at Enron, Tyco, Madoff funds,
Stanford Financial and countless others can go to jail for lying,
cheating, and running a Ponzi scheme, certainly Bernanke and Paulson
and everybody privy to this transaction can go to jail for securities
fraud and market manipulation?

The truth is unlikely to ever come to light. Ken Lewis himself is in a unique situation. He can't tell the complete truth otherwise he incriminates himself by admitting that he did a deal that he knew was bad for shareholders. He also can't strongly defend the deal because then he just looks like an idiot because he overpaid when the whole world knew in a few days Merrill's stock price would collapse. So he is stuck avoiding the tough questions and being elusive. I guess essentially he was at the wrong place at the wrong time.

This entire episode confirms that at the end of the day nobody is "Holier Than Thou". Bernanke can sit up there and wax eloquent about the stability of the financial markets. Yet in an extraordinary time of stress of the financial markets he manipulates a public transaction.

In extreme times of stress people do shady things and everyone has skeletons in their closet. Perhaps our only salvation in this country is that we are less shady than everyone else.